TL;DR - When reviewing or negotiating US term sheets, founders should thoroughly understand: valuation, board and management changes, liquidation preference, voting rights and change of control, vesting and capitalisation changes.
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Tags - term sheet, US term sheet, term sheet negotiation, term sheet advice, US venture capital, US VC
- What are some things that founders should understand and watch out for when reviewing or negotiating US term sheets?
- When reviewing or negotiating US term sheets, founders should understand the following concepts:
- Valuation and total financing amount
- Pre-money valuation: the value of a company prior to the investment round
- Post-money valuation: the value of a company following the investment round
- Establishes what percentage of a company that investors will own following their investment.
- If the pre-money valuation of a company is $3,000,000 and investors put in $2,000,000, making the post-money valuation of the company $5,000,000, the investors will own 40% of the company following the round.
- Assuming no special controls in place or stock with supervoting power for the founders, this means the investors have roughly 40% of the voting power.
- A high valuation is not always the best thing; it could lead to loss of control and early employees’ motivation if it requires founders to relinquish a significant percentage of equity or accept
- For many US-based companies, equity is the best way to retain good talents; devaluing/diluting equities can demotivate them and even cause them to leave.
- Board and management changes
- The investor investing the most money (“lead” investor) will often request one board seat.
- US VCs often connect companies with complementary portfolio companies to boost the overall value of the investments (can stimulate the company’s growth).
- However, for founders, this also means losing some control.
- In many cases, if there are three founders, one of them will be asked to step down to accommodate the first “preferred director”.
- If the company raises more in financing, the board composition will change such that the founders may eventually lose majority control
- Without certain protections, the board may be able to demote/fire the founders, change the company’s direction, or force to sell it.
- As the board grows, the company should strive for an odd-numbered board and consider adding independent directors to avoid any deadlock resulting from an evenly-numbered board.
- Founders should consider providing their minor institutional investors with a “management rights letter”.
- Liquidation preference
- Refers to the amount of money an investor will receive if the company liquidates.
- Pertains to the type of “downside protection” investors seek when the company underperforms.
- Expressed as a multiple of the initial investment (usually start at 1x - meaning in a liquidation invent, investors will get back $1 for every $1 they put in)
- If a company is doing poorly or in bad circumstances, investors may attempt to negotiate it up to 1.5 x or 2x and beyond in extreme cases.
- Generally, where there are not enough funds to pay out everyone as part of liquidation, it will require that the preferred holders be paid before founders/employees.
- Can be “participating” or “non participating”
- Participating: after the preferred investors receive their initial liquidation preference, they also are entitled to “participate” with the common stockholders (i.e. founders/employees) in receiving proceeds.
- Non-participating: simply returns the investor’s liquidation preference in a liquidation event
- A participating preference or a preference beyond 1x warrants particular attention
- Voting rights and changes of control
- Classes of stock
- Common stock: held by founders, given to employees, consultants, and other service providers, and generally has one vote for every one share
- Preferred stock:
- Generally has one vote for every one share plus other rights, privileges, and preferences over the common stockholders
- Can generally convert into common stock at a preferred stockholder’s option/upon certain events (company sale/liquidation)
- A substantial part of term sheet negotiation deals with particular voting and control rights attached to the preferred stock.
- Usually, certain “protective provisions” give some of the preferred stockholders particular voting rights before the company can take action (sale, changing the size of the board, etc)
- Series of stock: each class can have separate series (series A, series B, etc) - founders issue a series of preferred stock as part of their financing
- Drag along provision: requires founders and major shareholders to vote in favor of a “change of control” (e.g. merger or sale of a company) if the board and a certain percentage of stockholder vote in favor of it above founders’ objections.
- Special voting rights can mean less control for founders.
- Founder and employee vesting and capitalisation changes
- US VCs usually request for founder and employee vesting.
- Means founders/employees allow the company to repurchase their shares if the employment relationship is terminated (there may be some exceptions for certain types of terminations).
- US VCs may also ask all employees to be subject to standard vesting terms.
- US VCs may ask companies to make substantial capitalisation changes before investment (e.g. repurchasing inactive founding members’ shares or terminating employment relationships).
Follow up links:
- Management rights letter, https://avc.com/2020/01/the-management-rights-letter/#:~:text=A%20management%20rights%20letter%20is,with%20the%20management%20of%20the
- Participating vs non-participating preferred stock, https://www.lightercapital.com/blog/participating-or-non-participating-preferred-stock-whats-the-difference/
- Share vesting, https://linkilaw.com/startup-advice-tips/what-is-share-vesting/